U.S., China find their economies more joined than ever

BEIJING—Every weekday, Hu Xiaolian, a mother and skilled swimmer, arrives at her office in Beijing's west side and takes actions that affect the monthly mortgage and credit card payments of tens of millions of Americans.

Peering through her wire-rimmed glasses, Hu monitors a bank of four computer terminals and offers a guiding hand as China invests some of its $875 billion in foreign-currency reserves, greater than any other nation on Earth.

So far, Hu's actions have been gentle on Americans. She and China keep snapping up long-term U.S. Treasury bonds and other securities. The steady purchases slow the rise of U.S. interest rates, spurring Americans to keep loading their shopping carts with inexpensive "Made in China" products.

China's readiness to press the "buy" button on U.S. Treasury bonds underscores an emerging reality: China has growing leverage over the U.S. economy. Like Japan in the 1980s, China's exporting prowess is leading it to buy more U.S. debt. And as China Inc. strengthens, its leverage will only grow.

If China were to stop buying U.S. Treasury bonds—or suddenly dump its holdings—most Americans would feel it fast. U.S. interest rates would buck upward. Millions of homeowners with variable-rate mortgages or large debt would screech in discomfort.

China's newfound leverage gives some U.S. national security watchdogs indigestion. They warn of emerging vulnerabilities and say that China's economic clout may ratchet up the cost for the United States to carry out policies that Beijing opposes.

But China is feeling no joy in its position. And therein lies another aspect of the new financial reality: The rising vulnerabilities run both ways. If China wants Americans to keep buying cheap Chinese products, then Beijing has to keep pouring its savings into U.S. Treasury bonds, even though the sinking dollar makes the bonds less attractive. The economies of the two countries have grown evermore intertwined.

"China is a hostage to this situation. It cannot move out," said He Fan of the Institute of World Economics and Politics, a Beijing think tank. "If we sell (U.S. bonds), then the U.S. dollar will certainly drop."

Indeed, any Chinese sell-off would ring bells in trading rooms around the globe.

"Everybody else would know about it in a minute. The price (of the U.S. dollar) would plummet. They would be shooting themselves in the head," said Andy Rothman, a China strategist for CLSA Asia-Pacific Markets, a Hong Kong-based brokerage and investment bank.

Much of the drama plays out in secret. China shields key money managers from the media. People like Hu decline almost every media request for an interview, even as China's foreign reserves grow at an astounding rate of $20 billion a month, heading toward $1 trillion by the end of this year.

From her post as director of the State Administration for Foreign Exchange, the 47-year-old Hu oversees the investing of China's foreign reserves.

"She's very modest and candid," said Wang Songqi, editor in chief of The Banker, a glossy private magazine, and a friend since the early 1980s.

Chinese authorities don't even whisper whether they'll diversify their holdings of U.S. Treasury bonds or mortgage-backed securities, knowing that such rumors would move markets.

Chinese experts like Wang look befuddled when asked whether China's expanding holdings of U.S. reserves comprise a security threat to the United States.

"It's a danger to our own security," Wang retorted. "I think the trend is for the dollar to weaken. In the long term, China's holding of U.S. Treasury bonds will present China itself with risks."

Economists like Wang say the People's Bank is handcuffed to a U.S. currency that's likely to fall in value, hobbled by the yawning U.S. deficit and huge trade imbalances.

China's economy is barely a sixth of the size of the U.S. economy. But it enjoys sustained hyper-growth rates and is considered the world's fourth-largest economy, after the United States, Japan and Germany.

China has become the low-cost workshop to the world. Commerce Secretary Bo Xilai repeatedly tells visiting U.S. dignitaries that Chinese-made products save U.S. consumers $100 billion a year at the checkout counter.

Yet China's economy has significant problems. Most Chinese workers have no social safety net. Workers save as much as 40 percent of their earnings for fear they may fall ill or lose their jobs. They don't spend much, so domestic consumption lags. While Chinese save too much, Americans save too little, confident that their safety net is strong.

"If you look at the economic structure, these two countries are binding together," said He, the economist. "Neither country can live without support of the other. But the global imbalances are making them more and more vulnerable."

Not everyone agrees about vulnerabilities. In a U.S. Treasury report in mid-May on China's exchange-rate policies, Secretary John Snow rejected demands that China be branded as a currency manipulator, saying he didn't see any sign of an imminent sell-off of dollar holdings or any move to diversify out of Treasury bonds.

Some experts say China's purchase of U.S. bonds has no downside.

"It's clearly a very positive thing. Basically, what the Chinese are doing is taking money they are earning from goods they are selling in the United States and plowing it back into U.S. securities," said Rothman.

"It is difficult to come up with a reason that it is bad unless you are paranoid."

The Sino-U.S. trade relationship "is extremely healthy for both countries," added Michael Pettis, a former investment banker who now teaches at Peking University's Guanghua School of Management. China is helping stimulate U.S. demand for its low-end goods, he said, and is moving up the value chain slowly, even as it seeks to expand such sectors as the automotive industry.

Pettis rejected some critics' notion that China is engaged in mercantilism—increasing national power through building a favorable balance of trade, accumulating reserves and developing agriculture and manufacturing.

"If you really want to be an old-fashioned mercantilist, you'd say that China would be losing out," Pettis said. "You'd say China is reinforcing its position at the low-end of the market. ... Let's face it: Making automobiles is not high tech any more."

Some experts say the weaknesses of both nations make them co-dependent.

"I personally think it's too high a level of interdependence," said Brad Setser, a former Treasury Department economist who now works for Roubini Global Economics in New York City.

Setser said the concern isn't whether China will sell off its U.S. Treasury holdings. "The key point is that they have to keep buying. If they want U.S. consumers to keep buying, it's not enough to maintain their holdings. They have to keep buying new debt," he said.

Wang, the banking magazine editor, said he had little doubt that China would continue its steady purchases.

"China thinks the U.S. economy will be in good shape over the long term. Why? Because it has long-term productivity gains and it has comparative advantage in high-tech industry," he said. China, on the other hand, "has low productivity. China has lots of waste. Also, China consumes high volumes of energy."